Credit Trends

Pension plans are making news-from local and state governments to large corporations. They are being cut back, eliminated or, for many, in trouble without the workforce recognizing the extent of the problem.

Most firms have been forced to prop up their plan’s health with additional cash contributions, while many other firms are simply hoping the financial markets, as they did during 2009, will bail them out.

Meanwhile, for others, the plans are so underfunded, it is just a matter of time before the inevitable takes hold-larger than expected contributions or a bailout by the Pension Benefit Guaranty Corp. Those firms have been able to make it this far due to overzealous actuarial assumptions which have moderated the true liability. However, with both stocks and hedge fund performance below zero the past three years, which firms stock prices are the most vulnerable?

The list below shows the bottom 20% of that S&P grouping, with each firm on the list underfunded to the extent such amounts to at least 5% of both their total debt (including capitalizing the operating leases, shown as a separate column), and 5% of its current stock price.  Many are in much more precarious position, as is shown.  In addition, each company on the list has both an expected return on plan assets and a discount rate at least equal to the market average. Of the S&P group of companies, the average investment assumption is 8% and the average discount rate 5.8%, both of which is presently too high and understates the true liability confronting firms with defined benefit plans. The firms on the list have expectations greater than that! Also shown are last fiscal year’s plan contributions, benefits paid and projected benefit obligation (PBO).

The PBO is the actuarial present value of all benefits earned by an employee as of a specified date for service rendered prior to that date plus projected benefits attributable to future salary increases. Indicated is the funded status of a pension plan as either overfunded or underfunded, however, all of these firms plans are currently underfunded as of their latest fiscal.

The underfunded status of defined as the sum of:

1. Pension – Long Term Asset

minus the sum of

1. Pension – Current Liability
2. Pension – Long-Term Liability

Accumulated pension plan benefits are reflected at present value to remain on a comparable basis with plan assets. The assumed rate of return on assets is the discount rate used to arrive at the present value of plan benefits.

If the financial market does not bail these firms out, the alternative could quite well be additional significant  and currently unforeseen contributions which will impair reported and expected earnings, cash flows, return on invested capital, and cost of capital.

I would strongly urge all investors in these firms to thoroughly review the actuarial soundness of their plans as this represents significant  risk that can be avoided prior to the headlines.

Disclosure: No positions

Kenneth S. Hackel, C.F.A.
President
CT Capital LLC

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To learn how to analyze pension soundness and the pension soundness and the pension footnote and reporting requirements, please pre-order “Security Valuation and Risk Analysis“, out this fall from McGraw-Hill, by Kenneth Hackel, C.F.A.

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If the equity market were to rise less than 7% this year, the following firms would be particularly impacted. Column 3 shows some firms have expected returns of 9%, which would appear particularly optimistic, especially since all firms on the list have plans that are underfunded by at least $1bil. and have a substantial asset allocation to equities.

Disclosure: No positions

Kenneth Hackel, C.F.A.
President
CT Capital LLC

www.credittrends.com

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A story that never received the proper publicity during the bull market of 2009-2010 was its very positive (savior) effect on pension funding status, and employer contributions. The rise in equity markets allowed many hundreds of billions of dollars to appear on the balance sheet as equity instead of having to be spent to plug the pension gap.

But most of those firms which benefited are not out of the woods, as the negative stock performance during 2010 is sure to re-introduce such large employer expenditures which could very well impair security analyst estimates.

The following is a list of firms which

• Have, for their most recent fiscal year, accrued a greater expense for their pension plans than they actually contributed;
• Have seen a decline in the value of their plan assets over the past 2 years;
• Have either maintained or increased their discount rate (assumed rate of return) over the past 2 years;
• Have seen an increase in their pension benefit obligation over the past 2 years.

Table 1[1]

Source: S&P Data Services, Company reports

Presumably, firms which have suffered a decline in their plan assets should not be forecasting an increase in their settlement rate, which is the rate their projected benefit obligation could be settled. Firms might do this to show a lower liability and to lower their plan contributions. Their auditors and actuaries should only allow this for a short time before demanding stepped-up contributions.

The following table shows, for the same firms in Table 1, last year’s pension expense as a percentage of net income, the funded status of their plans, these firm’s total debt which to which we include operating lease obligations and shareholders’ equity.

Table 2

Source: S&P Data Services, Company reports

While there might be to some, a number of surprising names on the list, keep in mind that additional large funding into the plans would most likely cause a disappointment to earnings estimates, even though the firm might have the credit capacity to fund with low cost of capital. In the game of expectations, such firms are particularly vulnerable given their funding status and have not, of late, contributed their actual expense.

Several firms on the list look particularly vulnerable. One such is Goodyear Tire (GT), whose plan (see Table 3 summary below) is very underfunded, they have not had the financial ability to catch up, and have a high cost of capital. However, as the list shows, many firms are vulnerable.

Table 3

Source: S&P Data Services, Company reports

The pension and other post-retirement benefit area should be receiving greater scrutiny that it currently receives, as time is sure to tell.

Kenneth Hackel, C.F.A.

President, CT Capital LLC
www.credittrends.com

Data Source: Research Insight, CT Capital, Company 10Ks

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[1] Pension-Funded Status Indicates the funded status of a pension plan as either overfunded or underfunded.  This item is the sum of: Pension – Long Term Asset  minus the sum of  (1) Pension – Current Liability and (2)   Pension – Long-Term Liability

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